Competition policy in dynamic markets

International Journal of Industrial Organization 19 (2001) 613–634 www.elsevier.com / locate / econbase

Competition policy in dynamic markets David B. Audretsch a , *, William J. Baumol b , Andrew E. Burke c a

Institute for Development Strategies, Indiana University, SPEA 1315 E, 10 th Street, Room 201, Bloomington, IN 47405 -1701, USA b CV Starr Center, New York University and Princeton University, New York NY, USA c University of Edinburgh, Edinburgh, UK

Abstract Competition and antitrust policies have been based on a scholarly tradition focusing on static models and static analyses of industrial organization. However, recent developments in the industrial organization literature have provided significant advances moving beyond the traditional static models and the pre-occupation with price competition. In particular, the field has now developed to consider the organization of industries in a dynamic context. These new approaches are dynamic in the sense that performance is related to variations in the products available to consumers, as well as variations in firm competencies, ranking, growth, entry and exit. The development of the industrial organization literature also incorporates models of industry and market evolution. The purpose of this paper is to provide a framework linking what is known in the industrial organization literature on the dynamics and evolution of markets to one of the major policy instruments — competition policy. This framework provides a basis for understanding the contributions of the contents of the Special Issue devoted to Competition Policy in Dynamic Markets.  2001 Elsevier Science B.V. All rights reserved. Keywords: Competition policy; Dynamic markets JEL classification: L4; L5; O3; L1

* Corresponding author. Tel.: 1 812-855-6766; fax: 1 812-855-0184. E-mail address: [email protected] (D.B. Audretsch). 0167-7187 / 01 / $ – see front matter  2001 Elsevier Science B.V. All rights reserved. PII: S0167-7187( 00 )00086-2

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1. Introduction Competition (or antitrust 1 ) law lays down rules for competitive rivalry. It comprises a set of directives that constrain the strategies available to firms. Most of these directives seek to prevent behaviour whose aim is either to reduce the rivalry of firms, or to exert monopolistic power. An ethos which holds that ‘competition is good’ underlies the purpose of the law. Even its various names — antitrust law (US) and competition law (EU) — indicate that the law relates primarily to interfirm rivalry. The US law is most explicit in its prohibition of particular types of interfirm co-operation. Similarly, lawyers who practice under these laws use the term ‘anti-competitive’ to describe business behaviour that violates antitrust law. If there is any body of law that owes its existence to economics, it is surely antitrust law. It is therefore surprising that ‘enhancement of welfare’ is not explicitly adopted as the primary objective of this law. For traditional static economic analysis, this may not seem to be a major problem since perfect competition is often (if rather inaccurately) taken to be virtually synonymous with welfare maximisation. Thus, measures that increase the intensity of competition are automatically assumed to enhance welfare. Furthermore, legal practitioners and business managers can more easily evaluate the intensity of competition than the concomitant welfare effects. Thus, consideration of practicality may lead to emphasis on competition rather than welfare. However, industrial economics has advanced substantially from its exclusively static foundations and its pre-occupation with price competition alone. In a dynamic economy competition in product and process innovations may have a more significant effect on welfare, at least in the long run, than does any likely variation in price. Developments in the productive efficiency of firms and the quality of their products, as well as their growth, and the ease, with which they can enter or exit, can be critical. The industrial organisation literature has also begun to incorporate much of the Austrian and evolutionary viewpoints into mainstream thought. Industrial organisation analysis differentiates among productive, unproductive and destructive firm rivalry and implies that the distinction does not lend itself to simple rules of thumb. ‘Laws may suggest, but welfare must govern’ may be an apt conclusion. In sum, the evolution of industrial economic thought has raised questions about the appropriateness of at least some of the current antitrust / competition laws and practices and their adherence to a static blueprint. The issue has become increasingly urgent as innovation and growth have increasingly characterised the markets of the industrialised economies (Audretsch, 1995). The purpose of this special issue of this journal is to investigate this claim. Our

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We use the terms interchangeably throughout.

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call for papers elicited a substantial number of submissions and we regret that we can only provide a select few of them here. We were forced to turn down many valuable papers but will no doubt encounter many of them in other reputable publications. It is noteworthy that, despite other differences, virtually all the papers submitted concurred with the view that current competition laws do not adequately promote welfare in dynamic markets. Section 2 of this introductory article provides an overview of the recent evolution of industrial economic thought. Section 3 offers a characterization of the contents of this special issue. Section 4 illustrates the legal emphasis on static competition with reference to EU competition law. We conclude with a review of some of the questions the discussion raises about the current state of the US and EU antitrust laws.

2. Recent developments in the economics of industrial organisation We turn next to an overview of the evolution of the economics of industrial organisation and its relation to competition policy. We will stress the difference between the static mainstream models and the modifications proposed for incorporation of the process of change, both in mainstream analysis and in more heterodox work. These intertemporal approaches include those employing game theory, as well as the work of the Austrian school and the recent dynamic analyses based on gross adjustment and evolutionary approaches to firm and market performance. The origins of industrial economics are usually traced back to the work of Bain (1956) who introduced the Structure–Conduct–Performance (SCP) paradigm. In this framework, industries with high levels of concentration are taken to exhibit market power when firms charge monopolistic prices. These prices, in turn, affect economic performance (economic welfare). Thus, in Bain’s schema the roots of economic inefficiencies are found in industry structure, since in the SCP paradigm causation runs from structure to conduct and then to economic performance. The SCP literature was criticised by two groups. Economic theorists were unhappy that though SCP analyses were empirically based, they lacked rigorous foundation in economic theory (for a survey see Davies et al., 1989). Consequently, the Bain School of industrial organisation was sometimes dismissed as being based on ‘lofty’ intuition. However, the apparent success of the SCP approach in explaining phenomena of reality stimulated interest in the creation of a more robust theory of industrial organisation. This literature since the 1970s has recognized that conduct can influence structure and has abandoned the unidirectional flow of causation fundamental to the SCP framework (see Tirole, 1988, for a compendium of much of this research). The application of game theory to industrial organisation and an understanding of endogenous forces affecting market concentration indicated that structure is as much dependent on conduct, as

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conduct on structure. In many instances these attributes were shown to be simultaneously determined by the strategic action of firms. For example, endogenous barriers to entry, limit pricing and alteration of industry technology through R&D were found to affect industry structure. As a result, the strong correlation between conduct and structure reported in the empirical literature was no longer accepted as evidence that structure determines conduct, since it is equally consistent with the feedback loop hypothesis that conduct and structure mutually affect one another. Game theory also illustrated that small adjustments in economic models can generate large changes in the competitiveness of firms’ behaviour. For competition policy this implies that small variations in the basic circumstances of an industry can often be sufficient to make the difference between warranted and unnecessary regulation. Sutton (1991) described the ironic consequence of more rigorous theoretical analysis of markets when he observed: . . . within any particular model there are often many outcomes that can be supported as equilibria. This richness in modelling has made it much easier to provide a theoretical rationale for a wide range of observed phenomena: from predatory pricing to vertical restraints, our tool kit has been greatly enriched. The sting in the tail, however, lies in the old taunt, ‘‘With oligopoly, anything can happen.’’ 2 Thus ideally, the theory even raised the possibility that a unique applied economic analysis may be necessary for the formulation of competition policy for each particular industry. However, despite the complexities of the new theory the main thrust of its prescription for competition policy remains intact in its conclusion that economic welfare is usually increased by movement from more monopolistic to more competitive circumstances. The main change lay in the revised criteria of competition and monopoly that now emphasized conduct rather than structure. This suggested that EU and US competition laws did not require redrafting but merely some re-interpretation. For example, the term ‘dominant position’ could no longer be equated with industry concentration, given the importance of potential entry. The core of the game and non-game theoretical contributions to industrial organisation entailed a new emphasis on dynamics. Firms with dominant positions did not necessarily adopt prices that maximize immediate monopoly profits, since they had to consider the dynamic implications of such a strategy and the possibility that it would encourage entry (and hence competition) in the future. Similarly, firms were recognized to pursue long-term goals in conducting nonprice strategies in activities such as R&D and advertising. This new emphasis was

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Sutton (1991), p xiii.

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to prove important in terms of reliance of the design of competition policy upon the concept of perfect competition as the model for maximisation of welfare — making it almost the raision d’ etre of antitrust law. In general, economists have refrained from reliance on perfect competition as a guide to minimisation of welfare losses. Yet they have continued to think of it as the most illuminating model for guidance in policy formulation, partly because of their usual concerns about allocative inefficiency. Another plausible explanation of their continued affection for the perfect competition model is the encouragement to rent seeking provided by the presence of monopoly profits (which are sometimes labelled ‘rents’ since they originate from ownership of a monopoly resource) (see, for example, Tullock, 1967; Krueger, 1974; Posner, 1976). In this scenario monopoly rents induce agents to attempt to siphon-off some of these earnings (for example, through litigation or slack efficiency) which in turn forces monopolists to defend themselves, in the process using up resources that might otherwise be devoted to production. It is conceivable that such misallocated resources cumulatively can add up to a value in excess of the monopoly rent. But whatever their magnitude their mere existence makes monopoly losses exceed the standard dead-weight loss triangle. If so, even the theoretical monopoly that practices perfect price discrimination, and incurs no dead-weight losses, may yield economic welfare less than that provided by perfect competition. In less theoretical terms, competition is favoured by economists and by the law because it forces firms to pursue efficiency, product improvement and vigorous innovation. In the words of Judge Learned Hand in the noted Alcoa decision (1945) ‘‘Possession of unchallenged economic power deadens initiative, discourages thrift and depresses energy . . . Immunity from competition is a narcotic, and rivalry a stimulant to industrial progress’’. In addition, non-economic objectives also underlie the widespread conviction that competition law should use perfect competition as a guide. Thus, in their text, Scherer and Ross (1990) tell us We begin with political arguments, . . . because when all is said and done, they, and not economists’ abstruse models, have tipped the balance of social consensus toward competition. One of the most important arguments is that the atomistic structure of buyers and sellers required for competition decentralises and disperses power.3 Egalitarian objectives may also play a role. However, and whatever the reasons cited for the preferability of perfect competition, it must be recognized that even in theory this state of affairs is not a guarantee of welfare maximisation, even in the static model. Perhaps the most important reason is the widespread presence of

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Scherer and Ross (1990), pp 18–19.

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substantial externalities and spillovers that, as is well known, can lead to inadequate investment in innovation and to serious resource depletion and degradation of the environment. But it has other deficiencies. For example, in the absence of subsidies, uniform pricing may prevent suppliers from covering their costs, notably their fixed and common outlays, even though their products, that offer a surplus to consumers, could be supplied viably under price discrimination. There are other more traditional arguments about the shortcomings of price competition in certain circumstances, as in the case of a natural monopoly operating in an unstable market (for an overview of this literature, see Sharkey, 1982). In the new dynamic models of industrial organisation the usefulness of the perfect competition model becomes even more questionable. An early group of critics of this standard on dynamic grounds were the members of the Austrian school of economics, led by authors such as von Mises and Schumpeter and more recently by Demsetz, Shackle and Kirzner. The Austrians argue that economists in the classical tradition misuse the term ‘competition’ by applying it to a state of affairs rather than to a process. They argue that the static models of industrial organisation did more to explain where the market would end up (given some initial conditions) after enterprising activities were to cease, rather than explaining how it got there. However, they note that such static end-states are rarely relevant because ongoing entrepreneurship ensures that innovation hardly ever pauses sufficiently long for anything like static equilibrium to emerge. As Herbert and Link (1982), among many others, have pointed out there is no role for the entrepreneur in static economic theory: . . . Neoclassical value theory . . . took ends as given, explained allocation of scarce resources to meet these given ends, and focused attention on equilibrium results rather than adjustment processes. It therefore left no room for entrepreneurial action; the entrepreneur became a mere automaton, a passive onlooker . . . 4 In the static model where technology and consumer demand is given, price (output) becomes the firm’s main, if not its only, choice variable. The Austrians argue (for example, see Kirzner, 1973; Shackle, 1971) that in reality firms are engaged in a continuing dynamic competitive process, constantly creating and adopting new products and processes in order to gain a competitive advantage over their rivals. Firms that do obtain such an edge temporarily derive static monopoly power during the interval before imitating competitors replicate their innovation, or supersede it with one that is superior. Thus successful firms earn temporary monopoly profits as their reward for innovative activity. While in this scenario

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Herbert and Link (1982), p 52.

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successful firms do obtain ex-post monopoly profits (with their associated static welfare losses), if there is ease of entry and exit (little sunk cost) firms in the industry must expect only normal profits ex-ante, as firms will enter the industry up to the point where an additional firm expects to make zero economic profits. Ex-post the ‘losers’ do incur losses and the ‘winners’ do earn positive economic profits, but that only spurs innovation and growth. As a result, the Austrian prescription for competition policy is that industries with negligible barriers to entry should be left to operate without constraint. The importance of market contestability is emphasized by Kirzner (1973): . . . in the sense in which we have used the term ‘competition’ (a sense which, although sharply divergent from the terminology of the dominant theory of price, is entirely consistent with everyday business usage), the market process is indeed always competitive, so long as there is freedom to buy and sell in the market . . . we distinguish very sharply between a producer who is the sole source of supply for a particular commodity because he has a unique access to a necessary resource and one who is the sole source of supply as a result of his entrepreneurial activities (which can be duplicated by his competitors, if they so choose).5 The Austrian school takes the view that if governments intervene to reduce the profits of winners this will reduce the incentive for existing firms and prospective entrants to engage in competitive innovation. The Austrians conclude that only where incumbent firms have substantial monopoly power and undertake little innovation should competition policy interfere and undertake regulation.6 But even in such cases they are sceptical about the need for regulation because the presence of large profits is likely to attract enterprising competitors who will use innovation to facilitate their entry. The Austrians have often been taken to be related to the Chicago school whose adherents also take the position that regulation is unnecessary when markets are contestable. Economists in the Chicago tradition tend to the view that many if not most markets tend to approximate perfect competition in the long-run (see Posner, 1979). Thus positive profits are considered a transitory phenomenon since their presence stimulates entry and hence leads to their demise. Therefore the Chicago school argues that regulation is generally unnecessary because market forces ensure that monopoly power will usually be short lived. The emphasis of the Austrians is somewhat different, arguing that market performance can be constrained by scarcity of entrepreneurial resources and that the lure of possible monopoly profits is necessary to give firms the incentive to utilise these resources

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Kirzner (1973), pp 20–21. Most usually state-owned monopolies.

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in a manner beneficial to society. Thus, both advocate a laissez faire approach to regulation, but for very different reasons; the former on the presumption that the supply of entrepreneurs is infinite in the long-run while the latter concerns itself with the incentives needed to expand the limited supply of entrepreneurial resources. As far as direct regulation of firms is concerned, the laissez faire argument received some possible support from Baumol et al. (1982) theory of contestable markets, which demonstrated that in industries with no barriers to entry, the threat of entry would not only restrain incumbents’ market power, but also generally satisfy the requirements for static welfare maximisation. The theory has some roots in the work of Bain (1949) and rests on the premise that the toughness of price competition is influenced by potential as well as existing rivalry. If barriers to entry and exit are low, incumbent firms cannot afford the luxury of pricing above the competitive level since this will encourage entry. The authors of the theory, however, never claimed that most industries approximate the requirements of perfect contestability.7 In any event, the authors of contestability theory did not take a position that fundamentally opposed regulation, and argued instead that the theoretical concept of perfect contestability, because it is compatible with the presence of large firms and scale economies, is a better model for regulatory measures than is the at least equally theoretical model of perfect competition. The debate on the theory of market contestability has focused attention on the incentives for firms to enter an industry and to impose competitive pricing. However, little attention has been paid to the ability of entrants to compete effectively. If incumbents are to take the threat of entry seriously there must be a supply of capable entrants who are willing and able to respond to the profit opportunities created by monopolistic pricing. For example, in a contestable industry with a relatively high minimum efficient scale the supply of potential entrants may be restricted if they face liquidity constraints. In this case the incumbent may be able to charge monopolistic prices, regardless of market contestability, merely because there is an insufficient supply of able potential entrants. In the Austrian framework competition always benefits welfare. They believe that since competitive advantages are gained primarily by improving product characteristics and / or reducing production cost, a new state resulting from such competitive acts must generally be Pareto superior to its predecessor. The Austrians conclude that economic welfare is thereby improved, even allowing for

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Baumol et al. (1982) example of a contestable airline market was soon challenged by authors such as Graham et al. (1983), Bailey et al. (1981) and Moore (1982). Morrison and Winston (1987) arrived at a compromise position, holding that although potential competition may not cause prices to descend to the competitive level, it may nonetheless provide some restraint on monopolistic pricing.

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the role of market power in the process. It has subsequently been argued that their conclusion is incorrect on this issue, but a significant portion of the Austrian ideas has nevertheless been incorporated into mainstream industrial economics. To do this economists had to take dynamics into account, proceeding beyond the confines of static method. Thus, the evolution of industrial economics from static to dynamic analysis entailed a rediscovery of much of the central Austrian argument. It is important to stress here that we are not referring to dynamic analysis of static competition, as in repeated games of price (output) competition (where technology and demand are given), with collusive (tacit or overt) and non-collusive strategies. Such dynamic analyses illuminate the complex character of inter-temporal static competition but do not capture the central attribute of Austrian dynamic competition — in which the prime instrument is technology itself. Instead, our primary concern is the literature on technological change, innovation, research, development and diffusion. The conceptual origins of this literature are usually attributed to Nordhaus (1969) although there is an earlier, mainly empirical, tradition with contributions such as those of Griliches (1957), Carter and Williams (1959), O’Brien (1964), and Mueller (1966). This literature focuses on particular issues such as patents, copyright, and other intellectual property rights and the manner of their utilisation. It also includes analysis of trademarks, although these have considerably different conceptual ramifications (see Landes and Posner, 1987). The economics of advertising also can be taken to constitute part of these forms of non-price competition. In these analyses firms engage in enterprising behaviour in order to secure a competitive advantage over their (actual or anticipated) rivals. The research illustrates that there is something to be learned in this arena from the arguments of both the classical and the Austrian schools. The Austrians have made clear that product and process innovators who incur costs and take risks must be rewarded for their actions via positive economic profits in each static sub-period. At the same time, the classical tradition is correct in drawing attention to the static welfare losses generated by these positive profits as firms produce less than the perfectly competitive level of output. As is well documented in the literature on patents, there are few compelling reasons to suppose that dynamic competition will lead to the optimal monopoly profit in each period. Clearly, it can be either greater or less than that needed to yield the optimal degree of dynamic competition. Since the resources expended by losers may in some senses be wasted, there is no strong a priori reason to accept the Austrian presumption that such competition must always improve economic welfare. However, Lyons (1989) notes the consensus among economists that when the stimulation of innovation is necessary, some positive static profits are better than none: Without the prospect of monopoly profits the incentive to invent would be

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very much reduced . . . but it is almost certainly better than no protection at all for new ideas.8 Papers such as Gilbert and Newbery (1982) and Beil et al. (1995) have shown that the threat of entry can stimulate incumbents to increase innovative activity. However, a potential entrant who has the option of entering a market with the aid of some form of product or process innovation may have little incentive to do so if barriers to entry for subsequent imitators are sufficiently low to cause low ex-post profits. In this case the risk of entry is not worth taking. The intuitive explanation is identical to that in the literature on patents and copyright, where property rights ensure the possibility of some positive profits if the innovation is successful. Thus, efficient market regulation entails a sophisticated approach to property rights. On the one hand it must preserve these so that the incentive to engage in dynamic competition is maintained and on the other it must ensure that these rights are not employed to block entry to further rounds of dynamic competition. For example, this can occur through promotion of technological lock-in through the creation of network externalities emanating from protected innovation (Katz and Shapiro, 1981 and Arthur, 1989). Of course intervention such as this reduces the incentive for innovations involving network externalities. The dilemma for competition policy is that without prior knowledge of the economic benefits of such innovations and the minimum reward necessary to stimulate them one cannot ascertain with certainty whether such action will enhance or decrease economic welfare. There are other ways in which entrepreneurial activity can hamper competition. Thus, through means such as unwarranted litigation seeking government intervention to prevent ‘unfair’ competition, innovation that raises competitors’ costs or patents acquired to impede innovation by rivals, the generation of network externalities, etc., entrepreneurship can handicap innovation and reduce economic welfare.9 Such activity can entail innovative exploitation of rent opportunities. This line of analysis draws together a disparate body of literature which, although varied in focus, is consistent in refuting the common assumption that an increase in entrepreneurial activity is always welfare enhancing. Dynamic competition that gives rise to phenomena such as excessive product differentiation (Salop, 1979), excessive advertising (Sutton, 1991) and patent hoarding (Gilbert and Newbery, 1982) all serve as counterexamples. The analysis thus does indeed conflict with the presumption that dynamic competition is necessarily welfare enhancing. It immediately follows that even in dynamic markets where temporary monopoly profits serve to stimulate innovation regulation may be warranted if the

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Lyons (1989) p. 36. For example, Murphy et al. (1990) find a negative correlation between the size of the legal profession and economic growth in a sample of 91 countries. 9

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profits are derived from undertakings such as those just described or by their existence encourage wasteful rent-seeking. The economics of industrial organisation has also adopted a more disaggregated analysis of firm and market dynamics.10 This new approach brought the writings on entrepreneurship and industrial economics closer together. It sought to explain the evolution of markets rather than dealing with snapshots of the concentration and performance of a market at given points in time. The analytic method entails a flow approach to performance of the firm, disaggregating the gross movements that underlie changes in market performance. At the core of this approach is the belief that to explain the dynamics of economic performance one must be able to take into account the mechanism of change within the firm and of its response to modifications in its external environment. The new dynamic approach to industrial organisation has its origins in the work of Penrose (1959) and is also based on the contributions of evolutionary economics (see, e.g., Teece, 1980; Nelson and Winter, 1982), economic history (e.g., Chandler, 1962; Lazonick, 1982) business strategy (e.g., Porter, 1980; Peteraf, 1993) and regional analyses (e.g., Krugman, 1991). The new literature seeks to explain the process of competition within a framework that is dynamic but is nevertheless consistent with mainstream analysis. Thus, like the Austrian approach, it recognises that there are critical resources necessary to exploit opportunities for profit via change and that these can vary among firms, time periods and geographic locations.11 It was thereby recognised that market performance is as much influenced by variations in the ability of firms to exploit profit opportunities as it is by variations in the availability of profit opportunities. The evolution of industrial economics from its static base to its current dynamic form, that recognises that competition can sometimes be destructive and that firm capability plays a major role in determining market performance, raises doubts about the efficacy of current competition laws. These concerns are exacerbated by the foundation of these laws in the policy implications of static analysis. The volume of papers submitted to this symposium and the concurrence of virtually all of them with the conclusion that their are serious grounds for concern, is certainly suggestive.

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The new dynamic approach to industrial organisation extends the focus from the one dimension considered in the traditional literature to three dimensions (see Thurik and Audretsch, 1996) viewing industry performance in terms of an industrial, geographical and temporal dimension. The analysis also decomposes net changes in market performance into contributing component parts such as firm entry, exit, survival and growth. The rise in the importance of small firms has also led to significant industrial economics research (see Acs and Audretsch, 1989; Brock and Evans, 1989; Reid, 1993; and Storey, 1994, for discussions of this literature). Much of the intuitive analysis of the economics of entrepreneurship plays a significant role in this literature. 11 For example, new business ventures may be constrained by a lack of access to finance (Evans and Jovanovic, 1989).

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3. On the papers in this issue We turn next to a brief overview of the contents of this special issue and follow this with an overview of the questions raised for competition policy. The papers in this special issue concern themselves primarily with competition policy issues raised by three phenomena: variations in the capabilities of different firms, mergers and interfirm coordination, and the beneficial externalities generated by investment in R&D. The issue begins with two related papers, one by Malerba, Nelson, Orsenigo and Winter, and the other by Pleatsikas and Teece. They examine the role of increasing returns and the evolution of firms’ capabilities in high-tech sectors. Malerba, Nelson, Orsenigo, and Winter emphasise the role of evolving competences in firms’ performance in a model of the US computer industry. Their analysis highlights that antitrust policy (as manifested in interventions to break up monopolistic firms) has limited impact in industries where increasing returns are prevalent. The paper also emphasises that the effectiveness of such an initiative will be affected by its timing. They derive an interesting result — that attempts to enhance the capability of resource constrained firms in a market with inherent increasing returns may not affect the long-term performance of the market but can improve performance in adjacent markets. This can occur if the firms with enhanced capability use it to enter an adjacent market and thereby avoid the consequences of an impending shakeout in their current market. Pleatsikas and Teece critically assess traditional methods of analysing market definition and market power. They argue that these methods are inappropriate for high-tech industries which are typically characterised by high levels of product differentiation and dramatic shifts in firms’ market positions. Pleatsikas and Teece claim that traditional methods tends to define markets too narrowly so that market power is exagerrated. They conclude by suggesting several alternative methods which attempt to account for the dynamics of high-tech industries. The focus on firm capability continues in the next two papers, one by Burke and To, and the other by Boone. Burke and To illustrate how reductions in barriers to entry can lead to deterioration in market performance when the main threat of entry is posed by employees of the incumbents. In this model an incumbent’s employees are considered to be the most likely entrants since they are most apt to have the requisite knowledge and skills, the business contacts, demonstrated ability and motivation. Where this is so reductions in barriers to entry can affect market performance by forcing firms to raise the wages of employees with entrepreneurial inclinations, in a bid to prevent entry. In the long run the resulting wage increases can reduce hirings and raise prices. The result refutes the general presumption that a reduction in barriers to entry must reduce prices. Boone focuses on the role of variations in firms’ cost levels on the relation between competition and R&D. His model entails a non-monotone relationship between competition and R&D, which holds quite generally across a number of

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models. He further looks at the relation between competition and market structure. With asymmetric firms he demonstrates that when competition for consumers increases, industry concentration can rise as weaker firms are shaken out of the market. Thus, a decrease in concentration may indicate reduced competition among firms. This not only reverses the direction of causation in standard models but also the sign of the relationship between competition and concentration. The view that coordinated decision making by competing firms either by agreement or through merger is not always a bad thing emerges from the next two contributions, one by Baumol, and the other by McGuckin and Hguyen. Baumol recalls that where R&D entails significant externalities, private returns may be insufficient to generate the amount of R&D called for by welfare maximisation. In this case, Baumol argues, co-operation between firms may help to internalise these externalities and proves that they can increase R&D activity. If the process involves technology trading by the firms, this can contribute to welfare in a second way — by increasing the speed with which new and improved technology is disseminated and more widely adopted. The paper by McGuckin and Nguyen indicates that mergers are not typically undertaken to create static monopoly gains. Using US manufacturing data they find that ownership changes are not a primary vehicle for cuts in employment or plant closings, both of which would be likely if monopoly power was exploited through output reductions. Instead, the typical ownership change increases jobs and their quality as measured by wages. The paper by Link and Scott also addresses the tendency to insufficiency of R&D when externalities are generated by innovation. However, these authors argue that in cases where private returns are insufficient to encourage adequate investment in welfare enhancing R&D industrial policy becomes appropriate. They suggest that financial aid for R&D be auctioned to firms, thereby ensuring that government support for R&D is reduced to the minimum marginal financial incentive necessary for welfare enhancing R&D to occur. The following paper by Audretsch, van Leeuwen, Merkveld and Thurik illustrates that evolution of the capability of firms implies that the beneficial welfare effects of entry are underestimated. If one takes a static view, new firms may characteristically seem weak and hence they may appear capable of exerting only a limited influence on competition. However, Audretsch et al., take an intertemporal view and recognize that successful entrants are apt to become more capable with the passage of time. Thus their effect on competition becomes more significant in the longer run. They also argue that collective wage agreements can weaken dynamic competition because in their less capable and vulnerable stage, survival of new firms frequently requires them to have the opportunity to pay their employees less than established competitors do. The paper by Neumann, Weigand, Gross, and Munter considers the dynamics of concentration when market size changes. They examine two forms of market growth relating to increased globalisation and income growth. In a model they

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demonstrate the key role of entry barriers, namely that an increase in market size will tend to cause deconcentration as long as entry is facilitated. This is complemented by an empirical analysis of the dynamics of German industry where they find that the deconcentration process appears to be impeded by significant entry barriers. Finally, Konings, Van Cayseele and Warzynski assess the impact of temporal and regional variation in the form of competition policy on price-cost mark-ups in Belgium and The Netherlands. They find that competition policy seems to be less of a constraint on price-cost margins in The Netherlands than it is in Belgium. In general, they argue that the Dutch regulatory regime is less tough on monopolistic behaviour than its Belgian counterpart. They also find that the introduction of the EU style (conforming to Articles 81 and 82 of the EC Treaty) competition law to Belgium in 1993 appears to have had no measurable impact on Belgian price-cost margins. Overall, three general themes have emerged from our overview of the literature. First, the dynamics of the competitive process are far more complex than its static structure. For competition policy it follows that dynamic welfare optimisation does not lend itself readily to simple rules of thumb, which are more readily possible for the case of monopoly viewed statically. This implies that effective competition law must take account of this heterogeneity and must adopt clear welfare objectives that make allowance for the flexibility required in applying the law to dynamic markets. In particular, it is important that the law require employment of a time horizon that is sufficiently long and does not consider only short-term consequences of the behaviour of firms or of government acts of intervention. This requires consideration of the principles that should underlie the choice of this time horizon and the appropriate discount rate. Second, the capability of firms plays a critical role in dynamic market performance. Indeed, this is one of the main reasons why dynamic competition is far more complex than static competition. Thus, broad competition policy may appropriately go beyond prohibition of various types of behaviour and discouragement of particular types of structure, seeking means to increase the number of firms and prospective entrants capable of competing effectively (perhaps using means such as enterprise policy and education). Third, the consequences of mergers, alliances and co-operation among firms require re-evaluation in a dynamic context. In the next section we examine some implications of this and other observations that emerge from the material we have surveyed for current EU competition law.

4. Dynamic competition policy: the EU approach as illustration Next we discuss competition law and policy in the EU as an example of the implications of the discussions in this special issue. The main body of EU

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competition law is comprised of Articles 81 and 82 of the EC Treaty 12 and the national competition laws of the EU Member States. Articles 81 and 82 govern trade between EU Member States, while national competition laws set the rules for intra-member state commerce. EU competition law is fairly uniform across the EU, as national legislatures have gradually amended domestic competition law, deliberately adapting it to the contents of Articles 81 and 82. Given the dominant role of the model of static competition in the early years of industrial organisation analyses, it is not surprising to find that the European Union’s competition law (which was framed in this era) pays homage to this viewpoint. Article 81 outlaws agreements that create market power, while Article 82 restrains the use of market power. To a significant extent, Article 81 attempts to affect industry structure by restricting agreements that facilitate concentration and the creation of market power, while Article 82 emphasises anti-competitive conduct by outlawing abuses of market power. We will deal with each in turn. Article 81(1) — see below — prohibits (while Article 81(2) declares void) a particular set of agreements that seek to create or enhance market power. The list emphasises agreements associated with static monopoly. Thus, a traditional price fixing cartel would fall foul of Articles 81(1) a–c, which deal with price fixing, output restriction and market sharing, respectively. Similarly, Article 81(1) d prevents an upstream monopolist from undertaking discriminating agreements with downstream firms when they lead to monopolistic pricing in downstream markets. In the same fashion extension of monopoly power by tying the purchase of a product in a competitive market to a complementary product in a monopolistic market is outlawed by Article 81(1) e. In fact, Article 81(1) can serve as a useful device for students seeking to memorise the list of possible anti-competitive acts of a static monopolist, as recounted in an intermediate microeconomics text. In contrast, dynamic monopoly behaviour, such as excessive innovation activity by an incumbent firm in order to prevent a resource-constrained entrant from evolving into a more capable competitor, is not explicitly prohibited by Article 81(1). Perhaps it can be argued that Article 81(1) b can be invoked here, but the difficulty is that — in line with the concern over the limiting of production by static monopolies — Article 81(1) b emphasises insufficient rather than excessive innovation. Moreover, Article 81(1) does not deal with welfare reducing strategies associated with dynamic competition, such as pre-emptive patenting, excessive advertising, innovative rent seeking, excessive product differentiation, and weakening of the capability of resource constrained competitors.

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The EU merger guidelines are set out in Regulation (EEC) No. 4064 / 89 while state aid and public enterprise are covered by Articles 86–89 of the EC Treaty.

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4.1. Article 81 1. The following shall be prohibited as incompatible with the common market: all agreements . . . which have as their object or effect the prevention, restriction or distortion of competition within the common market, and in particular those which: (a) directly or indirectly fix purchase or selling prices or any other trading conditions; ( b) limit or control production, markets, technical development, or investment; (c) share markets or sources of supply; (d) apply dissimilar conditions to equivalent transactions with other trading parties, thereby placing them at a competitive disadvantage; (e) make the conclusion of contracts subject to acceptance by other parties of supplementary obligations which, by their nature or according to commercial usage, have no connection with the subject of such contracts. Dynamic considerations are brought into play through Article 81(3), which declares that Article 81(1) may be inapplicable if an agreement

. . . contributes to improving the production or distribution of goods or to promoting technical or economic progress, while allowing consumers a fair share of the resulting benefit, and which does not: (a) impose on the undertakings concerned restrictions which are not indispensable to the attainment of these objectives; ( b) afford such undertakings the possibility of eliminating competition in respect of a substantial part of the products in question. This article refers to the trade-off between dynamic and static efficiency familiar in the economics literature. It consequently acknowledges the need for a positive price-cost mark-up (and hence acceptance of second best allocative efficiency) to cover continuing sunk costs associated with R&D. However, Article 81(3) provides no unambiguous guidance on the right balance between these competing objectives. Of course, any economist will recognise that 81(3) must implicitly refer to economic welfare but the law does not mention it. Therefore, there is no legal declaration that clauses such as ‘‘ . . . allowing consumers a fair share . . . ’’ (Article 81(3)) should be interpreted in terms of economic welfare. In legal practice, economic welfare is mentioned, but the absence of explicit instructions gives substantial leeway to the Commission and the courts to choose what they consider to be the correct formulation. Furthermore, the law treats static inef-

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ficiency and the abuses that produce it as its main concern. Not surprisingly, therefore, the practice of EU competition law is frequently criticised for rulings that are inconsistent (possibly because of the absence of a clear social welfare objective) and biased in its emphasis of realised short-run profits over profits to be expected in the future (for examples see Korah, 1994). Article 82 is virtually a mirror image of Article 81(1) except for the removal of article 81(1) c dealing with agreements to share markets. It provides no exemptions (such as those offered in Article 81(3) for Article 81). Even more than Article 81 — which gave some guidance on the requisites for exemption under 81(3) — Article 82 relies on the Commission and the courts to interpret this pivotal term. Article 82 also specifies no social welfare objective and the sub-articles of the law emphasise abuses associated with static inefficiency. For dynamic welfare, it is perhaps somewhat comforting that Article 82 is rarely used in legal practice because lawyers have found it too difficult to prove that a firm’s actions constitute an abuse of market power. Instead, they usually opt for the easier task of demonstrating that the agreement behind the action is anti-competitive, as defined by Article 81.

4.2. Article 82 Any abuse by one or more undertakings of a dominant position . . . shall be prohibited . . . Such an abuse may, in particular, consist in:

(a) directly or indirectly imposing unfair purchase or selling prices or other unfair trading conditions; ( b) limiting production, markets or technical development to the prejudice of consumers; (c) applying dissimilar conditions to equivalent transactions with other trading parties, thereby placing them at a competitive disadvantage; (d) making the conclusion of contracts subject to acceptance by the other parties of supplementary obligations which, by their nature or according to commercial usage, have no connection with the subject of such contracts. We have noted two shortcomings from the viewpoint of dynamic efficiency in EU law: lack of clarity on the social welfare objective of the laws and an emphasis on static efficiency. We have argued that the economic prescription for competition policy is relatively simple only if one ignores such phenomena as variation in the abilities of different firms to exploit particular profit opportunities and the evolution of such capability with the passage of time, or the manipulation of barriers to entry or the incentives for innovation and its possible abuse as a means to undermine competition.

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5. Issues for competition policy in a dynamic world It would clearly be premature and even presumptuous to attempt to provide a menu of policies for regulation and anti trust activity in a world economy in which evolution and change are the hallmarks. However, the materials in this volume certainly suggest a list of questions to be raised about traditional procedures and objectives as well as issues that must be resolved in the design of rational policy. The basic attribute that differentiates the dynamic approach to competition policy is a focus on innovation rather than prices and profits and on flexibility in resource utilisation rather than static efficiency in their assignment at a given moment. A reorientation toward flexibility means that policy makers must be less concerned about ensuring such things as the existence of ‘the right number’ of firms and more upon the ease with which that number can be changed. Increased attention to innovation may make interfirm coordination and bigness less undesirable than it would be in an economy in which change is rare and insignificant. These considerations give rise to some obvious issues. 1. Appropriate ease of entry: a prime requisite for desirable flexibility in resource utilization is elimination of inappropriate impediments to entry. One approach is to use — perhaps co-ordinate — enterprise policy in order to increase the capability of new entrants. Another involves restricting incumbents’ response to entry but here considerable care must be exercised. Denial of such flexibility to the incumbents patently does make entry more attractive and can serve to give the newcomers breathing space to develop their capability to a point where they can stand on their own. But at the same time this can encourage the use of resources by incapable and inefficient new enterprises that would not survive if the incumbents were permitted fuller freedom to compete. The danger, ultimately, is that one may end up with an arrangement governed by the infant industry argument, and that, as has many times been said, there is little incentive for the infants ever to grow up. The problem for a dynamic economy, then, is what limitations upon the behaviour of the incumbents, if any, and what incentives or capability support for the entrant, are truly welfare promoting. 2. Appropriate interfirm coordination: in a static model, the welfare reducing consequences of collusion among horizontal competitors are clear. However, where innovation rather than price is the prime means by which welfare can be increased the desirability of preventing coordination is not so clear. Theory suggests that a primary disincentive for investment in innovation is its substantial spillovers, the fact that a considerable proportion of the benefits of an innovation often go to others than those who have produced it. This is particularly likely to inhibit the innovation process when competitors are among the prime beneficiaries. Technology trading by rivals can help to internalise these externalities and can consequently be welfare increasing, particularly in the long run. Moreover, coordinating firms may be able to afford the outlays the innovation process

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requires. The implication, then, is that the rules distinguishing permissible from impermissible coordination among competing firms must be rethought for a highly dynamic economy. 3. Innovation, trade and monopoly power: innovation has led to an explosion of the share of an economy’s output and consumption that is exported and imported. Maddison (1995) estimates that since 1820 the share of world GDP that is involved in international trade has risen 13-fold, a truly incredible number. This rise is, of course, largely attributable to innovation in transportation and communication technology, and there is no reason to expect it to come to an end in the foreseeable future. This is and will continue to be a crucial influence increasing ease of entry. Industries that are highly concentrated when that attribute is examined in domestic terms alone are apt to be far from concentrated or at least substantially contestable in a global economy. The obvious issue is the way in which rivalry from abroad should be taken into account in competition policy. 4. Anti-competitive innovation: in a world in which innovation is the firm’s prime competitive weapon, that weapon can sometimes be misused. Firms can, for example, engage in pre-emptive innovation and patenting in order to make it more difficult for entrants or even current rivals to provide viable innovations of their own. Or firms may engage in what may be deemed predatory innovation, for example, spending so much on R&D that rivals cannot afford to match the outlays and are driven from the market. What rules and procedures are appropriate to deal with such possible courses of action? 5. Monopolisation in an innovative market: it is sometimes claimed that in innovative industries monopoly power is generally highly transitory. This can reduce the incentive for the outlay of effort and resources on an attempt to acquire monopoly power by means other than innovation. Should competition policy explicitly be required to include the innovativeness of the industry, along with ease of entry and absence of concentration as evidence that monopoly power is unlikely and that where it occurs it is of limited importance because its duration is likely to be brief? 6. Price discrimination where R& D costs are substantial and continuing: in industries where innovation is a main instrument of competition, expenditure on the development of an invention can not be considered an irrelevant sunk cost that has been incurred once and for all. Survival of the firm requires continual large outlays on the innovation process. But these expenditures do not enter marginal costs. Uniform pricing based on marginal cost may evidently prevent recovery of the innovation outlays and destroy the firm. Only price discrimination may enable it to survive. How should competition policy adapt itself to this problem? When should price discrimination not be discouraged, and what circumstances will provide the firm with the power to adopt the required non-uniform prices? Evidently, this list can easily be expanded. Its purpose is not to lay out the

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problems of design of competition policy for a dynamic economy in any detail, but to indicate the sorts of issues that it raises.

6. Conclusion The special issue set out to investigate the claim that antitrust law addresses static inefficiencies but often neglects dynamic considerations. In this paper we reviewed the contents of the special issue and provided an overview of the evolution of the economics of industrial organisation from the viewpoint of competition policy. We found that EU competition laws do appear to emphasise static welfare optimisation. It is also apparent that an economic analysis of dynamic markets is more complex and yields a much richer depiction of competition, than that of static markets. But much work still needs to be done before economics is in a position to provide a defensible and comprehensive set of prescriptions for an economy whose most enduring attribute is rapid change. Yet it is easy to conclude that if one were to start all over again and design antitrust policy from scratch, the result would be rather different from current law and current practice.

Acknowledgements The authors would like to thank Steve Martin for his support, encouragement and advice throughout the duration of this project.

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